Like many other Chinese stocks, Daqo New Energy is currently trading at a low price below its book value. The stock price has been influenced not only by the sentiment towards China but also by the higher interest rates that impact the industry in which the company operates. However, in the long term, the renewable energy sector is expected to grow, potentially making Daqo New Energy a promising investment at its current price. This is the focus of my analysis.
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Since I have attended the workshop with Phil Town, I have decided to change the layout of my analyses a bit. I will do some more calculations and also briefly go through why the company has meaning to me. I have changed the format of the analysis a bit to try to make it shorter and with less numbers. If you want to read more about how I evaluate a company, please go to "MY STRATEGY" on my website.
For full disclosure, I should mention that I own shares in Daqo New Energy. However, I will not let my ownership of the company influence this analysis, and I will try to remain as unbiased as possible. If you would like to view or make a copy of my portfolio, you can find instructions on how to access it here. If you want to purchase shares or fractional shares of Daqo New Energy, you can do so through eToro. eToro is a highly user-friendly platform that allows you to get started on investing with as little as $100.
Daqo New Energy is a Chinese company that was founded in 2006 but did not go public until 2021. It is a prominent manufacturer of high-purity polysilicon for the global solar photovoltaic industry. It is one of the world's lowest-cost producers of high-purity polysilicon. All of Daqo New Energy's manufacturing operations are based in China. They have operations in Xinjiang and have recently expanded to Inner Mongolia, an autonomous region in China. In 2023, they produced 197.831 metric tons of polysilicon, and they expect production to increase in 2024. Daqo New Energy is the third-largest polysilicon producer in the world, following Tongwei and GCL Technology, both of which are Chinese as well. Chinese producers benefit from subsidized capital expenditures, low raw material and labor costs, as well as inexpensive electricity costs. This has allowed Chinese producers to establish a competitive advantage over producers from other countries. While there is still competition inside China, I would say that Daqo New Energy has a toll moat that protects it from international competition.
The CEO is Xiang Xu. He joined Daqo New Energy as a director in 2007 and has held various positions until he became the CEO in August 2023. He holds an EMBA (Executive MBA) degree from Nanjing University. He has significant expertise in the solar industry and corporate management. He is also the son of the founder, Chairman of the Board, and the largest individual shareholder in Daqo New Energy. I haven't been able to find much information about Xiang Xu, but he has worked in the solar industry for most of his career. Considering that he is the largest shareholder in the company, it can be assumed that he has a vested interest in the success of Daqo New Energy. Thus, I will give Xiang Xu the benefit of the doubt, despite the lack of information.
I believe that Daqo New Energy has a toll moat. While I don't have much information about the management, I will give it the benefit of the doubt because of their vast experience in the sector and large share ownership. Now, let us investigate the numbers to see if Daqo New Energy meets our criteria for a strong moat. In case you want an explanation about what the numbers represent, you can refer to "MY STRATEGY" on the website.
The first metric to be examined is the return on invested capital (ROIC). Ideally, a 10-year historical analysis demonstrating growth rates exceeding 10% annually would be preferred. Daqo New Energy, having gone public in 2021, provides data for the last three years only. The company exhibited remarkable ROIC in both 2021 and 2022, primarily due to elevated polysilicon prices. However, 2023 has presented challenges as the decline in polysilicon prices has significantly impacted Daqo New Energy's performance. Given the cyclical nature of the industry in which Daqo New Energy operates, ROIC is expected to remain volatile. Although achieving a ROIC exceeding 30% may be improbable in the foreseeable future, an increase in ROIC to surpass 10% would be a favorable outcome.
The following numbers represent the sum of the book value + dividend. In my previous format, this was referred to as the equity growth rate. It was the most important of the four growth rates I used in my analyses, which is why I will continue to use it in the future. As you are accustomed to seeing numbers in percentage form, I have decided to provide both the actual numbers and the year-over-year percentage growth. Since Daqo New Energy's initial public offering (IPO) occurred in 2021, data is available for the past three years, with growth rates calculated for the past two years. Daqo New Energy experienced substantial growth from 2021 to 2022, although there was a slight decline in equity in 2023. It is noteworthy that the equity only decreased marginally in 2023, despite it being a particularly challenging year for Daqo New Energy. Considering the impact of 2023's challenges on other metrics, such as the ROIC mentioned above, and the free cash flow to be discussed below, the relatively small decline in equity can be viewed positively.
Finally, we will analyze the free cash flow. Free cash flow, in short, refers to the cash that a company generates after covering its operating expenses and capital expenditures. I use levered free cash flow margin because I believe that margins offer a better understanding of the numbers. Free cash flow yield refers to the amount of free cash flow per share that a company is expected to generate in relation to its market value per share. It is noteworthy that Daqo New Energy has reported positive free cash flow in all three years since its IPO. Although free cash flow significantly decreased in 2023 due to the continued decline in polysilicon prices, the fact that Daqo New Energy maintained positive free cash flow is encouraging, particularly as many of its smaller competitors did not achieve this. Despite a 64% decrease in free cash flow, the company's ability to remain cash flow positive under challenging conditions is commendable. While it is unlikely that Daqo New Energy will replicate its 2022 free cash flow levels in the near future, I anticipate the company will continue to generate positive free cash flow. Although the levered free cash flow margin declined in 2023, it remains relatively high, which is another positive indicator. The free cash flow yield suggests that Daqo New Energy is trading at a very low valuation, a topic that will be revisited later in the analysis.
Another important aspect to consider is the level of debt. It is crucial to determine whether a business has manageable debt that can be repaid within a period of three years. This is assessed by dividing the total long-term debt by current earnings. An analysis of Daqo New Energy's financials reveals that the company has no debt. In fact, Daqo New Energy has remained debt-free since its IPO, which is a particularly encouraging sign. This is especially notable given that many companies in the industry are highly leveraged.
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Daqo New Energy, like all other companies, faces certain risks. One significant risk is the price of polysilicon. The price of polysilicon declined by more than 65% from 2022 to 2023, significantly impacting Daqo New Energy's performance. For example, Daqo New Energy's revenue was $2,3 billion in 2023, compared to $4,6 billion in 2022, which management attributed to lower polysilicon prices. This price decline also affected profit margins, with gross profit margins decreasing from 74,0% in 2022 to 39,9% in 2023, and operating margins dropping from 66,0% to 33,9% over the same period. The reduced polysilicon prices have led downstream manufacturers to lower utilization rates, reduce inventory, and delay orders to mitigate the impact of falling prices. Additionally, Daqo New Energy's customers are now postponing orders, anticipating further decreases in polysilicon prices. This creates a vicious cycle, putting additional downward pressure on polysilicon prices. Consequently, as long as polysilicon prices remain under pressure, Daqo New Energy will continue to be affected. Another significant risk is higher interest rates. High interest rates are particularly detrimental to solar companies. As the Motley Fool aptly describes: "In solar projects, there is a significant initial cost that usually necessitates debt financing, followed by modest revenue streams over the next 20 years or longer." At the end of the installation's useful life, the solar panels no longer hold value. Rising interest rates diminish the value of long-term cash flows because investors use a higher discount rate to evaluate them. Consequently, higher interest rates could potentially reduce the number of solar projects that secure financing or make it challenging for Daqo New Energy's customers to obtain the necessary funding to develop and construct solar projects. Management has mentioned that their customers have faced significant pressure from accumulated inventories and negative margins, which prevent them from initiating new projects. This situation, in turn, reduces the demand for Daqo New Energy's products. Capital allocation. Daqo New Energy maintains a strong balance sheet, boasting more cash than its market capitalization and no debt. However, the company has opted for a conservative approach to capital allocation in 2024 due to the current state of the solar sector. During Daqo New Energy's Q4 2023 earnings call, management discussed the implementation of a new share buyback program and the potential introduction of a dividend. In contrast, the Q1 2024 earnings call reflected a more cautious stance, with management emphasizing prudence in cash management and adopting a wait-and-see approach. Management also mentioned the possibility of investing in international expansion. This is notable given their previous statements indicating a lack of interest in international projects, which they noted would require five years of construction and an investment ten times higher than in China. Despite these considerations, I advocate for Daqo New Energy to repurchase shares, as they are currently trading significantly below the book value of $61.63 per share. Additionally, the company’s generous stock-based compensation program for its management is dilutive, reinforcing the need for a buyback program to offset this dilution.
There are several compelling reasons to consider investing in Daqo New Energy moving forward. The solar sector is poised for substantial growth, as solar energy has become one of the most competitive forms of power generation. The continuous reduction in costs for solar photovoltaic (PV) products and the associated decrease in solar energy generation costs are expected to create significant additional demand for green energy. Daqo New Energy primarily serves the Chinese market. According to the company, 2023 marked a significant milestone for renewable power growth in China, with newly installed solar PV capacity reaching a record high of 216.9 gigawatts, representing a 148% year-over-year increase. Management has indicated that they anticipate continued robust growth in solar PV installations in China in 2024. Moreover, trends such as the transition to electric vehicles are expected to further increase demand for solar energy. It is projected that 40% of all vehicles sold in China in 2023 will be electric, leading to increased energy consumption in the country. This, in turn, should drive higher demand for solar energy. Management has expressed optimism that Daqo New Energy will capture the long-term benefits of the growing global solar PV market. Increasing the production of N-type products. In the solar industry, there are two main types of products: N-type and P-type. N-type solar panels have an efficiency level of 25,7%, compared to 23,6% for P-type panels. A notable defect of P-type panels is light-induced degradation. P-type panels are doped with boron, which interacts with oxygen in the air, decreasing the panel's performance by up to 10% over time.
Daqo New Energy is focusing on N-type products, as the market transition to N-type products has been accelerating. This shift is driven by the higher price premium for N-type products, as well as their superior performance. Management has indicated that the current supply of N-type products is approximately 60.000 to 70.000 metric tons per month, while demand exceeds 100.000 metric tons per month. This indicates a lack of oversupply, unlike with P-type products. Currently, 72% of Daqo New Energy's production consists of N-type products. Additionally, new players in the industry are almost incapable of producing N-type products at this stage. As a result, Daqo New Energy is well-positioned to benefit from the ongoing transition to N-type products. A strong balance sheet. Management has highlighted that, at current levels, the entire solar value chain, including polysilicon, is likely to be loss-making in general. A significant number of polysilicon producers are currently unprofitable. The solar industry has experienced multiple cycles in the past, and based on management's previous experience, they believe that the current low prices and market downturn will eventually lead to a healthier market. Poor profitability and cash burn will force many market players to exit the business, potentially resulting in bankruptcies.
Management estimates that 70%-80% of companies are currently losing money, which is unsustainable. If these price levels persist, it is only a matter of time before several players will need to shut down, exit the business, or face bankruptcy. Management has projected that 25% of companies may shut down or go bankrupt in 2024. This will inevitably lead to capacity rationalization, addressing the current overcapacity issue in the sector.
Daqo New Energy, with its strong balance sheet, is well-positioned to withstand this downturn. The company is unlikely to face bankruptcy and stands to benefit when the industry returns to normal profitability, as there will be fewer competitors in the market.
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Now it is time to calculate the share price. I perform three different calculations that I learned at a Phil Town seminar. If you want to make the calculations yourself for this or other stocks, you can do so through the tools page on my website, where you have access to all three calculators.
The first is called the Margin of Safety price, which is calculated based on earnings per share (EPS), estimated future EPS growth, and estimated future price-to-earnings ratio (P/E). The minimum acceptable rate of return is 15%. I chose to use an EPS of 5,73, which is from 2023. I have selected a projected future EPS growth rate of 8%. Finbox expects EPS to grow by 8,1% in the next five years. Additionally, I have selected a projected future P/E ratio of 16, which is twice the growth rate. This decision is based on Daqo New Energy's historically higher price-to-earnings (P/E) ratio. Finally, our minimum acceptable rate of return has already been established at 15%. After performing the calculations, we determined the sticker price (also known as fair value or intrinsic value) to be $48,93. We want to have a margin of safety of 50%, so we will divide it by 2. This means that we want to buy Daqo New Energy at a price of $24,46 (or lower, obviously) if we use the Margin of Safety price.
The second calculation is known as the Ten Cap price. The rate of return that a company owner (or stockholder) receives on the purchase price of the company essentially represents its return on investment. The minimum annual return should be at least 10%, which I calculate as follows: The operating cash flow last year was 1.616, and capital expenditures were 1.111. I attempted to analyze their annual report to calculate the percentage of capital expenditures allocated to maintenance. I couldn't find it, but as a rule of thumb, you can expect that 70% of the capital expenditures will be allocated to maintenance purposes. This means that we will use 777,7 in our calculations. The tax provision was 166. We have 77,266 outstanding shares. Hence, the calculation will be as follows: (1.616 – 777,7 + 166) / 77,266 x 10 = $129,98 in Ten Cap price.
The final calculation is called the Payback Time price. It is a calculation based on the free cash flow per share. With Daqo New Energy's Free Cash Flow Per Share at $6,54 and a growth rate of 8%, if you want to recoup your investment in 8 years, the Payback Time price is $75,13.
I believe that Daqo New Energy is an intriguing company. While we have limited information about the management team, it is notable that the CEO is also the largest shareholder, a factor I typically find favorable. Daqo New Energy operates in a cyclical sector, and the current oversupply has caused polysilicon prices to plummet. This has significantly impacted the company, leading to a decrease in ROIC and free cash flow, while revenue and profit margins have been halved. Additionally, rising interest rates have resulted in fewer solar projects, placing significant pressure on Daqo New Energy's customers due to accumulated inventories and negative margins. This has constrained their ability to initiate new projects, thereby reducing the demand for Daqo New Energy's products. Despite these challenges, Daqo New Energy has opted for prudent capital allocation, which is somewhat disappointing given the low valuation of its shares. The company could have taken advantage of this to buy back shares, at least to the extent that share-based compensation would not dilute shareholders. Daqo New Energy operates in a sector expected to grow in the long term, despite the current cyclical downturn. Future energy consumption is anticipated to increase, and solar energy remains one of the most competitive forms of power generation. The company's focus on N-type products has increased, with N-type products comprising 72% of production in 2024, compared to 60% in 2023. The growing demand for N-type products should benefit Daqo New Energy.
With a strong balance sheet, Daqo New Energy can endure the cyclical low point of its industry, while many competitors may face bankruptcy. As competitors exit the market, the resulting decrease in supply should increase the demand for polysilicon in the future, benefiting Daqo New Energy. If you believe that solar energy is the future and can tolerate the volatility, I consider Daqo New Energy a potentially good long-term investment below the margin of safety price of $24,46.
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